Inheritance Tax Pitfalls of UK/US Marriages
Two countries separated by a common language and contrasting tax systems - Inheritance Tax Pitfalls of UK/US Marriages
Private Client Partner Frederick Bjørn analyses the estate planning traps of UK/US marriages and some of the planning opportunities available to mitigate inheritance tax liability
Considering UK/US marriages are so common, it is all too easy to assume that there is harmony between the countries' tax systems so that, providing you have planned for the future in one country this will be sufficient to cover you in the other. Unfortunately this is not the case. The purpose of this article is to demonstrate that failure to plan in both jurisdictions can have some surprising and objectionable consequences.
UK IHT Rules
The UK inheritance tax ("IHT") rules are based on the UK concept of domicile (which is wholly distinct from residence), and provide that a UK domiciliary is liable to IHT at 40% on his/her worldwide assets, whereas a non-UK domiciliary is only liable to IHT on UK situs assets. Whilst an individual may never become domiciled in the UK for general tax purposes, in the event that he/she has been resident in the UK in 17 of the past 20 years(Fn) he/she will be deemed domiciled for IHT purposes. It is often the mismatch between a couple's domiciles which results in an unexpected IHT exposure.
In the UK the 'spouse exemption' provides that there is no IHT on lifetime or death transfers between spouses. This gives comfort that on a financial level, at least, life should not be altered by the death of one of you. However, few people are aware that this exemption is limited on transfers to non-UK domiciled spouses. Until 6 April 2013 this limit, which is a lifetime limit and does not refresh, was a mere £55,000 and whilst this has now been increased to £325,000, in many cases this still results in a significant IHT bill.
Once the spouse exemption limit has been exceeded, then on the UK domiciliary's death his/her estate will be taxed at 40% (to the extent its value exceeds the nil rate band (currently also £325,000) and the estate is not eligible for any other IHT exemptions). This applies even to the deceased's interest in jointly owned assets (including the matrimonial home!) - an important consideration which is also often over-looked. The corollary is that there is a real possibility of the same assets being taxed on both deaths, causing hardship to the surviving spouse (following the first death) and leaving any children hoping to benefit disappointed.
So, what can be done about this?
The answer depends on the facts and the jurisdictions involved. From a UK perspective the public policy behind the IHT rules is that once assets have left the jurisdiction they are no longer taxable here and consequently to allow a universal spouse exemption would be to open up countless tax avoidance opportunities.
UK domicile election
Having said this, as well as an increased spouse exemption limit, 6 April 2013 saw the introduction of a 'UK domicile election'. This allows a non-UK domiciled individual who is married to a UK domiciliary to elect to be treated as UK-domiciled for IHT purposes only, with the result that the spouse exemption ceases to be limited and assets can be transferred freely between spouses both during lifetime and on death. Whether this is tax efficient overall will depend on the circumstances and it is not an election to be made lightly. However, the surviving spouse does have two years following the deceased's death to make the election and can subsequently 'lose' this UK domicile if he becomes non UK resident for at least four consecutive tax years.
Whilst the rules relating to an 'election' are beyond the scope of this article their impact is, in essence, akin to being deemed domiciled so that any planning may be similar to that described in Scenario 2 below.
Whilst the UK are wary of assets leaving their jurisdiction and tax net, so are the majority of other countries and none more so than the US...
Consequently, if you, or your spouse, has US connections US advice should be sought from the outset to establish whether US tax will be payable. It is key to understand whether liabilities arise under US law to establish your options under UK law and the extent to which you will need to rely on the US/UK Tax Treaty ("the Treaty"), if at all. In the absence of discussion between your US and UK advisors it would be all too easy to achieve a full tax saving in one jurisdiction whilst leaving complete tax exposure in the other. As the scenarios below demonstrate both jurisdictions may have taxing rights on the same individual but may not offer the same exemptions and reliefs.
Set out below are three scenarios which typically arise. For ease of analysis we have ignored the nil rate band and the limited spouse exemption. We have also skirted around any US exemptions, although these can be very valuable, as demonstrated by the current lifetime, transferable, tax free sum of $5.4million per spouse which can in fact help to make planning straightforward for a number of individuals.
In each scenario the aim is to minimise the overall liability to tax.
A UK domiciled husband (H), who is not taxable in the US, and his wife (W) who is a US citizen but who is neither UK domiciled nor deemed domiciled.
In the absence of planning, if H were to die first his estate would suffer full IHT at 40% (regardless of who benefited under his Will). If W were to die first there would be full US liability with no benefit from the US marital deduction, although there would be no IHT liability (for non-UK situs assets).
This is a common scenario and is often dealt with by incorporating a qualifying domestic trust ("QDOT") into W's Will, the effect of which is to defer tax on her death until the death of H. This is a US concept and would require US advice and drafting, but from H's perspective the assets on trust do not form part of his estate and consequently are not subject to IHT on his death. In the event that H were to die first, W could now elect to be treated as UK domiciled (as discussed above). However, if such an election were not made, thought would need to be given as to how H and W divide their assets and who should benefit from H's estate on death. The facts may point towards the availability of other exemptions or tax planning opportunities and it may be worth H making lifetime gifts to take them out of his estate, for example.
As for scenario 1, but W is now UK deemed domiciled (although she continues to be a US citizen).
From a UK perspective the spouse exemption would now be available both ways such that if H were to die first, he could leave everything to W outright with no IHT liability (and no immediate US issues). However, if W were to die first there would again be full US tax to pay with no US marital deduction available.
Whilst a QDOT might help in this scenario as well, it is important to consider the IHT implications resulting from W's UK domicile at the same time. In theory if W were to leave her estate on trust for H (a QDOT for US purposes and an immediate post death interest trust for UK purposes) then there should be no IHT or US tax charge on her death. The tax charges in both countries would be deferred in this case until H's death. However, for this to be effective it will be important for the US and UK lawyers to work together to ensure that the trust built into W's Will achieves this. Given the marked contrast in Will drafting between the two countries this may not be straight forward.
The couple have now moved to the US and have been living there for a number of years such that H, whilst still UK domiciled, is liable to tax in the US as a US resident (but not a US citizen). W has ceased to be deemed domiciled in the UK.
In the event H were to die first, H's estate would be subject to full UK tax on his death with no spouse exemption (due to his non-domiciled wife). Conversely, if W were to die first, there would be no marital deduction and consequently full US tax. On the face of it the couple's estates could be fully taxed on both the first and second death.
As for scenario 1, W's Will could include a QDOT such that the marital deduction would available in the event she were to die first. However, whilst there is no way of aligning the US and UK rules using domestic law in the event that H were to die first, the Treaty may provide an alternative. Realistically the Treaty will only be a useful option if both the UK and US positions are clear, which is why it is so important to seek advice from both sides. Whilst the aim of the Treaty is to bridge the Atlantic divide, it is a law unto itself, providing as it does a 'fiscal domicile' for each spouse and a series of tie-breaker tests in the event an individual is dual domiciled (which H will be under this scenario). Whilst the exemptions within the Treaty are very narrow and there is no guarantee that help will be at hand, in very particular circumstances the Treaty does provide for a full marital deduction in the US and a 50% exemption from IHT in the UK. This is clearly considerably more appealing than the original analysis which resulted in a tax charge on the death of each spouse.
Whereas scenarios 1 and 2 are likely to begin in our offices, assuming the couple are living in the UK, scenario 3 is more likely to present itself after US advice has been sought. Consequently, whilst your US lawyers may be quick to instruct UK counterparts, in the event they do not, you may find that you have incurred fees on US estate planning that has over-looked the UK implications; the result being that the US planning may not be UK efficient and will need to be re-considered, thus incurring more fees.
This article demonstrates the need to seek advice in both jurisdictions from the earliest opportunity. Whilst the standard tax planning opportunities may not be available in your particular situation there is usually a way to ensure that you are not prejudiced by your choice of spouse, at least from an estate planning perspective!
In the event that you do have concerns Payne Hicks Beach would be happy to advise on all aspects of your UK tax and trusts position and, whilst we are unable to advise on US law ourselves, we have extensive experience in liaising with and coordinating the advice of US lawyers to achieve the most efficient outcome for our clients.
(Fn) This will apply after 15 out of 20 years from 6 April 2017
If you wish to discuss how this proposal could affect your tax situation please contact your usual contact in the Private Client department at Payne Hicks Beach, or the author Frederick Bjørn (firstname.lastname@example.org)
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This publication is not intended to provide a comprehensive statement of the law and does not constitute legal advice and should not be considered as such. It is intended to highlight some issues current at the date of its preparation. Specific advice should always be taken in order to take account of individual circumstances and no person reading this article is regarded as a client of this firm in respect of any of its contents.
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